The Taxation Of Social Security Benefits As A Marginal Tax Rate Increase?

Executive Summary

Social Security benefits first became partially taxable in 1983, and the rule was expanded in 1993 to its current form. As the rules stand now, rising income can subject 50% or even 85% of Social Security benefits to taxation, until a maximum of 85% of all Social Security benefits are included in income for tax purposes.

The reason the taxability of Social Security matters is not just that it raises a client’s tax burden in the aggregate, but that it can boost a client’s marginal tax rate far above the tax bracket alone; those in the 15% tax bracket may actually face marginal rates of 22.5% to 27.75%, and those in the 25% tax bracket can see marginal tax rates spike as high as 46.25%!

Fortunately, this rate eventually reaches a cap – when the maximum amount of Social Security benefits are being taxed – and the client’s tax rate returns to normal. Nonetheless, while clients are going through the income levels where Social Security phases in – which can begin with as little as $25,000 of income for individuals – tax rates rise high enough that more proactive tax planning, from Roth conversions to the use of annuities and asset location strategies, becomes crucial to manage a client’s overall tax exposure!

How Social Security Benefits Are Taxed – Calculating Provisional Income

In order to determine the taxability of Social Security benefits, it’s first necessary to calculate “provisional income” – a measurement of income used specifically for these purposes. Provisional income is calculated as your total income from taxable sources (essentially the net amounts included on the front page of your tax return in calculating Adjusted Gross Income), plus any tax-exempt interest (i.e., from municipal bonds) and excluded foreign income, plus one half of your Social Security benefits. If this total exceeds $25,000 for individuals ($32,000 for married couples), then 50% of the excess is the amount of Social Security benefits that must be included in income. If provisional income exceeds $34,000 for individuals ($44,000 for married couples), then 85% of the excess amount is included in income. (Notably, if provisional income exceeds the 85% threshold amount, it must have already surpassed the 50% threshold amount, and there are some additional calculations to coordinate between the two, until a maximum of 85% of all Social Security benefits become taxable.) Some examples may help to illustrate:

Example 1. Jeremy and Martha have an AGI of $28,000 (and no tax-exempt or foreign income), and receive combined Social Security benefits of $14,000. As a result, their provisional income is $28,000 + $7,000 (half of Social Security benefits) = $35,000, which is $3,000 above the $32,000 threshold. This means that 50% x $3,000 = $1,500 of their Social Security benefits are subject to taxation, which ultimately increases their AGI to $28,000 + $1,500 = $29,500.

Example 2. Donald and Sarah have an AGI of $44,000 and receive combined Social Security benefits of $24,000. As a result, their provisional income is $44,000 + $12,000 = $56,000, which is $12,000 above the upper $44,000 threshold. This means that $16,200 of benefits are subject to taxation (which is technically 50% of the amount from $32,000 to $44,000 plus 85% of the excess above $44,000), which ultimately increases their AGI to $44,000 + $16,200 = $60,200.

Example 3. Paul and Megan have an AGI of $58,000 and receive combined Social Security benefits of $24,000. As a result, their provisional income is $58,000 + $12,000 = $70,000, which is $26,000 above the upper $44,000 threshold. This means that $20,400 of benefits are subject to taxation (which is the maximum 85% of the $26,000 excess above the upper threshold, capped out at 85% of their total Social Security benefits), which ultimately increases their AGI to $58,000 + $20,400 = $78,400.

The bottom line: as income rises, more Social Security benefits are subject to taxation, until eventually a maximum of 85% of all benefits are included in income for tax purposes!

How Social Security Taxation Boosts The Marginal Tax Rate

Because the formulas to determine the amount of Social Security benefits to include in income are themselves based on income, the net result is that the inclusion of Social Security functions like a surtax on income while it is phasing in. And because of the high percentage of Social Security benefits that become taxable as income rises, the effect can be significant.

Example 1b. Continuing the earlier example of Jeremy and Martha, if the couple decides to take another $1,000 out of their IRA, this will increase their AGI by $1,000 to $29,000. As a result, it will also increase their provisional income by $1,000, which leaves them $4,000 above the threshold, resulting in $2,000 of their Social Security benefits being taxable. In the end, this means Jeremy and Martha end out with a total AGI of $31,000… their AGI increased by $1,500 even though they only took out a $1,000 IRA withdrawal due to the taxation of Social Security benefits! If the couple is subject to the 15% tax bracket, their additional tax liability on $1,500 of income is $225, which equates to a marginal tax rate of $225 (additional taxes) / $1,000 (additional income) = 22.5%. In other words, even though the couple is in the 15% tax bracket, their $1,000 IRA withdrawal is subject to a 22.5% marginal tax rate due to the formulas triggering taxation of Social Security benefits!

Example 2b. Continuing the earlier example of Donald and Sarah, if they decide to take out another $1,000 from their IRA, their provisional income will rise to $57,000, and another $1,000 x 85% = $850 of Social Security benefits will be subject to taxation. This increases their AGI by $1,850, which leads to $277.50 of additional taxes. The end result: Donald and Sarah face a $277.50 / $1,000 = 27.75% marginal tax rate even though they’re in “just” the 15% tax bracket, due to their greater income triggering taxation of additional Social Security benefits at 85 cents on the dollar!

Example 3b. Continuing the earlier example of Paul and Megan, if they decide to take out another $1,000 from their IRA, their provisional income will increase to $71,000. However, since they are already capped at 85% of their maximum Social Security benefits being subject to taxation, their AGI simply increases to $59,000 + $20,400 = $79,400. In other words, because the maximum amount of Social Security benefits were already subject to taxation, another $1,000 of income simply increases their AGI by… $1,000! Assuming the couple is subject to the 15% tax bracket (which they should be after personal exemptions and itemized deductions), the additional taxes on $1,000 of income will be $150, which means their 15% tax bracket really does mean a 15% marginal tax rate!

Notably, the net result of these formulas is that while 50% of Social Security benefits are being phased in, the marginal tax rate is essentially boosted by 50%, from 15% to 22.5%. For those whose income exceeds the upper threshold, the marginal tax rate is boosted by extra 85%, from 15% to 27.75%! This essentially results in a tax bracket “bubble” that occurs as Social Security benefits are being phased in, until the maximum phase-in is reached and the client’s tax rate returns his/her normal tax bracket again.
For individual clients, the effect can be even more severe, because the taxation of Social Security benefits potentially overlaps not just the 15% tax bracket, but the 25% tax bracket (which starts at “only” $36,250 for individuals). As a result, individual clients face a potential tax rate boost from 25% to 46.25%!

Harry is an individual with $36,000 of income but a hefty $22,000/year of Social Security benefits. His Social Security provisional income is $36,000 + $11,000 = $47,000, which is $13,000 over the upper threshold for individuals. As a result, $15,550 of his Social Security benefits are subject to taxation (which is 50% of the amount from $25,000 to $34,000, plus 85% of the excess of provisional income above the $34,000 threshold), which puts his AGI at $51,550. Even after a standard deduction and one personal exemption, Harry’s taxable income would be $51,550 – $6,100 – $3,900 = $41,550, which places him in the 25% tax bracket.

If Harry now takes an additional $1,000 from his IRA, his provisional income increases to $48,000, his taxable Social Security benefits increase to $16,400, and his AGI rises to $53,400. The net result: Harry’s AGI increased by $1,850 for “just” a $1,000 IRA withdrawal, and with a 25% tax bracket his liability will be $1,850 x 25% = $462.50, which equates to a whopping $462.50 / $1,000 = 46.25% marginal tax rate!

In practice, it takes a unique combination of income and Social Security benefits to face this 46.25% marginal tax rate, although it is possible; due to how the tax brackets line up with the Social Security taxability thresholds, it’s more common for individuals than married couples (the latter generally don’t see this 46.25% marginal tax rate unless they are slowly phasing in a very large pool of combined Social Security benefits). And because the tax brackets are indexed for inflation while Social Security benefits are not, the overlap of 85% Social Security benefits inclusion and the 25% tax bracket is actually declining over time (as the 10% and 15% brackets widen slightly each year). Nonetheless, the fact remains that the phase-in of Social Security benefits can result in surprisingly high marginal tax rates for clients with relatively “modest” income levels – as even a 15% tax bracket can be boosted up to 27.75%!

Planning Around The Taxability Of Social Security Benefits

Planning strategies should be done based on marginal tax rates, which means the leaps in marginal tax rates from including Social Security benefits can and should be a material factor in planning – especially since the rates have the greatest impact on those whose income is relatively modest and may not realize they are exposed to 27.75% (or even 46.25%!) marginal tax rates when they “thought” they were in just the 15% or 25% tax brackets.

For many clients, though, the rates are at least partially unavoidable. In many situations, there simply is not enough income flexibility to spread income out to stay below the thresholds. Although notably, for some clients, the best thing to do is to actually accelerate income and lump it together; after all, additional income beyond the point that the maximum 85% of Social Security benefits are taxable is subject to only a 15% (or 25%) tax bracket, which is far better than leaving the income until next year when it may be taxed at 27.75% (or 46.25%) due to the phase-in of Social Security benefits. In fact, in some cases it might even be worthwhile to trigger a bit of additional Social Security benefits taxation just to reach the cap and then add more income beyond it at a current tax bracket!

In other situations, the best thing to do may be managing income earlier to avoid exposure in the later years. For instance, Roth conversions before a client starts Social Security benefits can leave a more flexible pool of money to draw upon in the later years – not to mention avoiding RMDs – allowing the client to avoid 22.5%, 27.75%, or 46.25% marginal tax rates down the road. Of course, the caveat for Roth conversions is still not to do too much at once, driving up the current tax rate to an untenable level, as the primary benefit of Roth conversions is still to do them when current rates are lower than future rates! Nonetheless, if the reality is that future tax rates will be 22.5%, 27.75%, or greater, then doing partial Roth conversions to fill the lower tax brackets now to avoid those higher marginal rates in the future is certainly a good deal. And alternatively, some clients who currently face these rates might still do partial Roth conversions getting through the taxability of Social Security benefits, so they can do additional Roth conversions that year above the Social Security taxability cap at favorable tax rates to further reduce exposure down the road.

Tax deferral strategies can also be appealing to manage Social-Security-triggered higher marginal tax rates. This might not only include just continuing to maintain and stretch tax-deferred IRAs (to the extent they’re not converted), but also the use of non-qualified fixed or variable annuities to defer income; while tax-deferral doesn’t eliminate exposure to the effect entirely, it’s nonetheless true that tax deferral itself is worth a whole lot more when the client’s marginal tax rate is so high! Similarly, effective asset location strategies to shelter the most high-income tax-inefficient assets also become more important where client marginal tax rates are so high.
On the other hand, it’s notable that strategies like investing in tax-free income to avoid high Social-Security-taxation marginal rates does not work, since municipal bond income is itself included in provisional income! The end result is that while the bonds themselves still wouldn’t be taxable, they would still face a 7.5% – 12.75% marginal tax rate (for those in the 15% tax bracket) as 50% or 85% of Social Security benefits become subject to taxation. Similarly, the impact can also boost the marginal tax rate for capital gains, which may enjoy a 0% tax rate for those in the bottom tax brackets, but nonetheless increase AGI and provisional income and therefore indirectly trigger the taxation of Social Security benefits.

Unfortunately, the reality is that no two clients will be exactly the same for their exposure to higher marginal tax rates from the taxability of Social Security benefits, because the exact scope varies depending on both the nature of their taxable income and the total amount of their Social Security benefits that may be subject to taxation in the first place. For some clients with smaller benefit payments, the impact is fairly limited; for others with a very large pool of payments, the effect can continue over a much wider range of income and spanning across not just the 15% tax bracket (with 27.75% marginal rates) but the 25% bracket (with 46.25% marginal rates). Ultimately, all clients will cap their exposure when the maximum 85% of Social Security benefits are being taxed, but the exact level of this cap itself will vary depending on the amount of Social Security being received. Which means in the end, the analysis must be done on a client by client basis… but with potential 46.25% marginal tax rates, it’s worth the effort!

Related

Mike Dayoub, CFP®

Agreed.

The progressively higher tax rates on Social Security income makes a stronger case for not taking benefits early, especially when one spouse continues to work. I tell clients “If you don’t take it early, the longer you live the smarter you’ll look.”

bob smith

This is terrible advice, and a great illustration why CPAs and CFPs are nothing but a “certified” waste of time and money. You are basically saying “you are smart if you don’t die early,.” Okay. We’ll all be sure not to die early.

Take your SS as soon as you can. There are no luggage racks on a hearse.

A few hours of reading on the bogleheads forums is worth more than 1000 so-called financial wizards.

Great article.

Troll hunter

They do like feeding the trolls over at Bogleheads. Group think and cognitive dissonance are dangerous.

Carolyn Pruitt

The government loves people who decide to wait until 70 to draw-not that many do. It is like the lottery when you do this-you are betting that you will live to draw it.

Alan Silverstein

Replying years later but I just saw this — yeah what I tell people considering deferral of any pension/SS that allows an early start is, “are you feeling lucky?” If actuarially flat, you must outlive your average cohort to come out ahead. However it’s been suggested that SS has unreasonably high discount rates (should be adjusted) and today the expected-return for deferral is positive for many people. However it’s also occurred to me that old age and retirement is a good time for “inflection of the gratification deferral curve” for many people. There’s more (intangible) to consider here than just the expected return math.

Carolyn Pruitt

But they need to consider that they might not look so smart if they only live long enough to draw it for a couple of years or not at all.

pcollen

In that case, they would have been happier prior to death with the higher monthly SS check, and never miss it after death would they. And their spouse would be entitled to a higher spousal benefit, so maybe the dead WOULD look “better” to the spouse in having provided better in the end. Think about it…..

This relates directly to one of your other articles on the new surcharges for Medicare Part B and D premiums. Notice the tiers for Social Security benefit taxation – 25 and 34k for singles and 32 and 44k for marrieds – are not indexed like tax brackets are, so over time, more and more people fall into the taxable Social Security benefits category.

When the tax went into effect in 1983, approximately 10% of people paid taxes on benefits. By 1993, that number had risen to 18%. 2004, it was 36% and 2014 it is projected to be 40%

The same is true for the new income thresholds for Medicare. Right now, they affect a small percentage of people, but over time more and more folks will be paying the higher Medicare premiums.

Both represent strong opportunities for advisors to deliver value to clients.

Carolyn Pruitt

This was the plan for it in 1983, that more and more of it would be taxable. 401k’s allowed tax advantages to wage earners and the eventuality that we would have to pay tax on that money has come to pass also.

Stan, CPA

At the end of the day SS benefits are taxed somewhere between 0% and 85% but never 100%. Thus a dollar of SS benefits will always be worth more than a dollar of say a fully taxable pension or a fully taxable IRA withdrawal or a dollar of wages. Thus one must be careful to always adjust SS benefits to a fully taxable equivalent (FTE) basis to reflect this inherent value so that when doing your financial analysis one never comingles pre-tax, post-tax, or partially taxable dollars.

First, no one said it would exceed 85%, but that’s not the point. The point is be aware of the MARGINAL tax rates.

Second,

$1 of SS is not always better than a $1 of wages. If you are single, collect $20,000 of SS and earn $11,500 part time greeting people at a local store, which money is better?

All the money is worth the same, and you will pay $0 taxes.

Thanks for playing, and I hope you don’t fleece your clients out of too much of their nest eggs.

Carolyn Pruitt

but we hope most people at 70 1/2 have some RMDs they will be having to make.

Carolyn Pruitt

Probably it will be a good idea for me to just consider that 85% of my social security will be taxable, because I continue to work and I don’t want to quit my job and live on investments, RMDs and my social security.

Thank you, Michael. Your examples should help advisors understand the surprisingly strong impact of incremental income for clients in the income ranges for which taxation of Social Security benefits is phasing in. For the purpose of reporting marginal tax rates in financial-planning software, I developed Excel formulas to compute those rates based on income levels with respect to federal income tax brackets, the Social Security thresholds, and other inflection points that occur in the tax code.

I also made a chart to illustrate the high marginal rates that you mention for intermediate income levels. Perhaps you can show such a chart when you speak on this topic.

While advisors serving high net worth clients might think they will not ever encounter Social Security taxation percentages below 85%, I have advised clients with more than a million dollars in assets who had a few years soon after retirement when provisional income was low and high marginal rates applied.

The Social Security Earnings Test, which reduces benefits for excess earned income above a certain threshold, applies to those who receive benefits before full retirement age (which was age 65, but now 66 for most of today’s retirees).

The taxation of Social Security benefits, however, is based on the income formulas noted here, and applies regardless of age. Anyone receiving benefits whose income crosses the thresholds in the formulas must include at least a portion of Social Security benefits in income for tax purposes.

BoomerMBA

I am a very analytical director of development in a faith-based organization with several strong recommendations. Many of your clients are generous tithers who would benefit mightily by using the IRA QCD in December 2013 for their 2014 charitable giving. This is perfect for those who take the standard deduction. Advisors should care about the use of the RMD and how it could reduce taxes.
Another thought: the tax free portion of Charitable Gift Annuity payments does NOT go into the provisional income calculation, unlike muni bonds income. The CGA may return twice the rate of the bond as well. OR, use the one-time deduction for the CGA to offset the accrued tax from old H bonds that are resetting to 1.5% or 0% ,yet hold old E or EE deferred income that is taxable. Again, a huge income and tax savings for certain seniors. Any denomination or faith-based charity would be happy to help.
Yes, I realize these are two completely separate suggestions. You can’t buy a CGA with a QCD.
Please consider the uses of charitable giving to achieve tax and income objectives. If a charitably inclined client is willing to consider tithing their estate, why not show them how to capture increased income and reap the tax advantages during their lifetime!

Carolyn Pruitt

My question is will the same IRAQCD suggestion be available for 2015?

mike b

very analytical – every heard of humility son?

Tom

I make 47,000 at my job My wife gets 7000 a year in social security. Should we file our tax separatly

Tom,
I can’t imagine that will be positive for you. Married couples filing separately is rarely an effective means to avoid the taxation of Social Security. It changes the threshold for triggering taxation of Social Security from $32,000 (for married couples) down to $0, in addition to triggering less favorable tax treatment for many other credits and deductions.
– Michael

Cheryl Lump

Get a “paper” divorce. The only thing it will effect is the tax man.

pcollen

My wife and I have an AGI of $120+ K, and that after contributing the max to 401K’s including Catch Up contributions. We have to take the standard deductions, too, as we have nothing to write off..we are debt free. I’m 66, but have no need for SS at this time, and if I filed for SS I would likely have to hand over perhaps half of my monthly checks back to the Gov. in the form of additional taxes. I haven’t worked the numbers, but that’s how I see it. So, I could be effectively taking a 50% reduction on my Soc Security by filing for it now . Still, I would be left with with the 50% of SS that I wouldn’t have had otherwise. I don’t know, but I’m betting that I will live long enough to enjoy the larger monthly checks after I hit 70 and quit working, and my wife may enjoy a higher spousal benefit as well….except HER SS may be larger than the spousal benefit from me and so she will not even take the spousal benefit…. things that make you go HMMMMMM…..

Mark Hugh

Our income and tax rate are relatively low right now, taking out money from investments as needed to live on at long term capital gains rates. We are deferring SS till 70 at which point our income from SS, small pensions and minimum distributions will be much higher, over $100,000. Usually, the rule of thumb is to not take out tax sheltered money if you don’t need it as long as possible. However, it appears that taking out that IRA/annuity money before 70 to live on makes sense while our income tax rate is low so that the taxes on them are much lower than they would be after 70 when our income goes up a lot, right? Also, I thought Roth held more than 5 years is not taxed and would have no effect on taxable income, right?

Alan Silverstein

Yup, in fact Vanguard wrote a report about this recently, suggesting that for lifetime minimal tax impact, defer SS (never mind the growth of benefits themselves) and distribute taxable tIRA dollars instead.

Alan Silverstein

Also, the two five-year clocks for rIRAs are not so simple, but basically irrelevant once you hit 59.5 and have had any Roth open at least 5 years. Yes, having previously contributed, converted, or grown Roth dollars available is a nice portfolio feature for annual income tax optimization.

Alan Silverstein

Great article. Been out a while but just came to my attention — after I wrote about the same topic (http://silgro.com/SS_EMTR.htm) although much more technically and not as friendly, plus you described some additional second and third order effects that hadn’t occurred to me.

Alan Silverstein

Hmmm your Disqus URL mechanism is broken, you must copy and paste my URL above, just clicking on it doesn’t seem to work (at least for me).

Alan,
Sorry for the confusion. With the URL in parenthesis, it seems that Disqus thought the last closing parenthesis was part of the URL (which it’s not), thus resulting in a broken link. :/
– Michael